One of the benefits of buying a home is the potential to see your investment in the property grow over time. An upward trend in the value of the home will certainly help, but to increase the possibility of a return on the investment, you want to begin building equity, and one potential obstacle to that is negative amortization.

According to the Consumer Financial Protection Bureau, “Amortization means paying off a loan with regular payments, so that the amount you owe goes down with each payment. Negative amortization means that even when you pay, the amount you owe will still go up because you are not paying enough to cover the interest.”

So how does negative amortization happen, and how can you avoid it?

How negative amortization happens

Some borrowers experience negative amortization with an adjustable-rate mortgage (ARM). An ARM is a home loan with an interest rate that fluctuates based on consumer indexes. Typically, after a three- or five-year fixed-rate period, your interest rates and monthly payments can rise or fall according to market trends. 

In order to protect borrowers from steep increases, some ARMs include a cap on your monthly payment. However, if rates rise enough, that maximum payment may not be enough to cover your monthly interest. When that happens, the unpaid interest is added to your principal, effectively increasing your loan balance rather than paying it down. Similar situations can arise with interest-only mortgages.

This can lead to more serious concerns for a borrower. If the housing market in your area experiences a downturn and your home value declines while your loan principal continues to increase, you may find yourself with an upside-down mortgage, meaning you owe more money than what your home is worth.

How to avoid negative amortization

The first step to avoiding negative amortization is to confirm with your mortgage servicer the type of mortgage that you currently have to determine your risk of encountering the situation. The simplest way to prevent negative amortization is by always ensuring your monthly payments cover the interest accrued. This could mean paying more than your minimum monthly payment. Another option is to refinance with a fixed-rate mortgage if you are in a situation where negative amortization is a likely outcome. 

If you’d like to learn more about finding the right mortgage for your situation, call Open Mortgage today and let one of our representatives help you explore your options.